TCS Daily

Second That Emotion

The
late Benjamin Graham -- erudite classicist, mentor to Warren Buffett,
highly successful investor and probably the greatest financial mind of
the 20th century -- said it best: "The investor's chief problem -- and
even his worst enemy -- is likely to be himself."

When it comes to money, our emotions often cause us to take stupid, self-destructive actions.

On
the other hand, you may be able to profit from this very phenomenon.
That's the thrust of an article in the new issue of the Bernstein
Journal titled "Exploiting the Effects of Emotions on the Capital
Markets." Before getting to the profit part, let's look at the weird
world of irrational decision-making, driven by emotion.

Last December, Daniel Kahneman of Princeton
won the Nobel Prize for his work integrating psychology and economics.
Kahneman, with his late collaborator Amos Tversky, wrote a landmark
paper in 1979 that advanced an idea called Prospect Theory. Their point
was that, under some circumstances, people aren't rational actors in
their economic decision-making; they are influenced heavily by their
emotions.

A
simple example is that consumers may drive across town to save $5 on a
$15 calculator but not to save $5 on a $125 coat -- even though the
gain is precisely the same.

One
of Kahneman's more striking discoveries is that people detest losses.
In one experiment, subjects were asked to choose between a gamble that
gave them an 80 percent chance of winning $4,000 and one that gave them
a 100 percent chance of receiving $3,000. Even though the first choice
was mathematically preferable, 80 percent of the subjects chose the
certain $3,000.

Then,
Kahneman offered a choice between an 80 percent chance of losing $4,000
and a 100 percent chance of losing $3,000. This time, 92 percent of the
subjects chose to take the gamble -- even though, mathematically, it
was the worse selection. Why the change? Because people really, really
don't like to lose.

As the article in the journal published by Sanford C. Bernstein & Co., the New York
money-management and research firm, says, "Real-world tests reveal that
people hate losing money even more than they like making it." The mere
chance of a loss is so frightening that many people prefer to make what
they believe are riskless investments, rather than making investments
which, over the years, have proven far more profitable with only
slightly more risk.

What
does this mean in real life? For one thing, a lot of people in their
thirties and forties direct part of their 401(k) retirement
contributions to money-market funds, a foolish choice. Also, "through
mid-2003," says the Bernstein Journal article, "investors were still
pouring more money into bond funds than stock funds, even though
interest rates had fallen to less than nothing after inflation and
taxes while the stock market was finally showing signs of life. . . .

"With
the taste of stock-market losses still sharp on their tongues,
investors ignored the facts. They kept rushing into bonds, thereby
almost assuring themselves little or no reward. Meanwhile, stocks rose
and fell and rose again, as is their wont, and ended the first half of
2003 with healthy gains."

Probably
the most intriguing -- and productive -- of the Kahneman-Tversky quirks
is called "anchoring." People tend to anchor their predictions in the
present; that is, they use prevailing conditions as their base and are
reluctant to believe that the future will be much different.

For
example, what would you say to an economist who predicted that
inflation would average 5 percent over the next 10 years? You would
probably have serious doubts because inflation has been just 2 percent
lately. But over the past 40 years, inflation has indeed averaged 5
percent, and "there's no reason it couldn't return to that level,"
notes the Bernstein Journal article.

Stock
analysts are especially prone to the effects of anchoring. "Research,"
says the article, "has proved that, when faced with a major change
ahead for a company, analysts will generally make a series of small
earnings-estimate revisions, each of them inadequate to reflect what's
really going on." Sanford Bernstein's own money managers exploit this
tendency by delaying the purchase of an attractive stock whose earnings
have been downgraded -- "because subsequent downward revisions are
likely and will probably further depress the price."

What
about companies whose earnings are rising? Back in February 1999, I
wrote about an investment firm that developed mutual funds to take
advantage of anchoring in just this way. The firm, Fuller & Thaler
Asset Management, is run by Russell Fuller, the hands-on manager, and
Richard Thaler, a well-known expert in behavioral (that is,
Kahneman-Tversky-style) economics at the University of Chicago.

Fuller
and Thaler look for stocks with big jumps in earnings. They then check
to be sure the earnings spike isn't a one-time-only event and that the
company is sound. Next, they look for analysts who underreact to the
change. "Say that the company reports earnings that go from $1 to
$1.80," Fuller told me in an interview in his office in San Mateo, Calif.
If he is an anchored analyst, he says, "I am so overconfident that I
give no weight to this new information in my next forecast. My first
reaction is to reject it."

The
analyst will eventually start raising his forecast, but since he's
still anchored at $1, he'll go to $1.40 rather than $1.80 or $2.
Finally, the analysts catch up to reality. Meanwhile, Fuller and Thaler
buy the stock at a relatively low price and ride it up.

To
begin, Fuller and Thaler search, especially, for small- and mid-cap
companies, where the judgment of only a few analysts can have a big
effect on prices. One of Fuller's favorite examples, when he was just
putting the theory to work, was office-furniture maker Herman Miller
(MLHR), which registered 10 consecutive earnings "surprises" after an
initial jump in 1993 that analysts wouldn't believe. The stock
sextupled.

The Fuller-Thaler team has managed two funds for the Undiscovered Managers group in Dallas.
The Behavioral Growth fund (UBRRX) has returned 57 percent so far this
year and an annual average of 10.3 percent for the five years ended
Sept. 30, compared with just 1 percent for the benchmark Standard &
Poor's 500-stock index. The Behavioral Value fund (UBVLX) is up 37
percent in 2003 and, launched later, has produced average annual
returns of 12 percent since October 2000, clobbering the S&P.

Top
holdings for Behavioral Growth include SanDisk (SNDK), which makes
flash-memory storage cards for cameras, music players and the like;
Gen-Probe (GPRO), maker of screening tests for HIV and other infectious
diseases; and Coach (COH), leather accessories.

Coach
is a good example of the anchoring phenomenon. The stodgy company was
revamped into a fashionable chain, stores were opened in Japan,
and earnings soared from 55 cents a share in fiscal 2000 to $1.53 in
2003, despite tough times for other retailers. But analysts and
investors couldn't quite believe it, so, instead of taking a big
one-time jump and leveling off, the stock has risen powerfully and
consistently -- from $8 in 2000, when the firm went public, to $31.43
today. As of Sept. 30, their last report, Fuller and Thaler still like
the prospects.

The
Behavioral Value Fund, which has a much larger portfolio (103 stocks
vs. 47) and leans toward companies with lower price-to-earnings ratios
(an average of 19 vs. 28), is headed by Gold Banc (GLDB), a
Kansas-based bank; Unova (UNA), technology for the automotive and
aerospace industries; and Primedia (PRM), magazines and video.

The fund's Web site explains:
"A Behavioral Finance approach to investing should be more sustainable
over the long term than traditional investment strategies, because
human behavior changes far slower than the ability of competing
managers to improve their information gathering and processing."

That
may be true, but Thaler himself has warned that you amateurs shouldn't
try this at home. "While behaviorists think that it is theoretically
possible to beat the market," he told the New York Times,
"individual investors do not have the time or the training to do that
on their own." But, judging from his record of the past few years, I
think Thaler has the knack. Be warned that the funds require a $10,000
initial investment and that, while there's no load, expense ratios
aren't low -- 1.3 percent for the value fund and 1.4 percent for growth.

The Bernstein article cites two other Kahneman anomalies with real-life lessons:

•
Regret: Imagine you find a lottery ticket on the street. A colleague
notices her birth date on it and offers to trade your ticket for hers.
Do you do it? Mathematics says, Why not? But psychology says something
else. "The majority of people prefer holding on to the original ticket
for fear that, if it proves to be the winner, they will have lost out,"
says the Bernstein Journal article. Regret almost certainly played a
role in the tech-stock boom when investors held inflated stocks that
were plummeting, "paralyzed by fear of selling just before the boom
rekindled."

•
Failure of initiative: This is the idea that problems can't or won't be
fixed. To the contrary, with established business, the likelihood is
that someone will eventually find a cure -- there's too much at stake
not to. "Would you have wanted to invest in IBM in 1993?" asked the
Bernstein Journal article. "Or Citicorp in 1991? Or Citigroup in 2002
for that matter? Yet, properly researched, companies in this kind of
situation can become the most profitable investments."

How
do you fight emotional, irrational responses to financial stimuli? One
way is to remember two words: "mean reversion." Abnormal moves in stock
prices tend to correct themselves over time, in both directions.
Bernstein looked at S&P stocks between 1974 and 2003 and found the
companies that performed the best over three-year periods fell off
sharply over the next three years. Companies that performed the worst
over three years did far better over the next three.

Bernstein
has recently been putting these lessons to work. The firm has been
highly enthusiastic about stocks -- in a wide variety of sectors,
especially finance and health, where bargains still abound. Among the
top holdings in clients' equity portfolios are Bank of Nova Scotia
(BNS), a Canadian bank; Golden West Financial (GDW), savings bank;
Pfizer (PFE), pharmaceuticals; Nissan (NSANY), Japanese autos; and
Hewlett-Packard (HPQ), technology.

In
the end, the best way to exploit the emotions of other investors is to
keep your own wits about you. Remember that nothing goes up -- or down
-- forever, that a little bit of risk is usually worth taking, that
turnarounds can be for real, and that the best deals today are often
the ones that other people are shunning.